Bank Risk-Taking and Misconduct

Sakalauskaite Ieva,
University of Amsterdam

I collect data on misconduct in major financial institutions to show that its intensity varies over the business cycle. While asset quality misrepresentations are most frequently observed at the peak of the business cycle, it seems that the likelihood of misconduct related to retail customers is highest when growth starts slowing down. To explain the latter dynamic, I propose a model that attributes changes in misconduct intensity to agency conflicts within banks. As the riskiness of projects preferred by bank shareholders start increasing, their reliance on short-term pay to induce managers to take risk makes it harder to prevent myopic managers from entering the workforce. As such managers are more willing to trade-off instant gains for future disciplinary actions, periods of increasing risk-taking and bonuses in the financial industry are also associated with more conduct failures.